Huntley Schaller

Regime switching in stock market returns

In this paper, we use an extension of Hamiltons (1989) Markov switching techniques to describe and analyze stock market returns. Using new tests, we find very strong evidence of switching behaviour. A major innovation of our work is to use a multivariate specification which allows us to examine whether the price-dividend ratio has marginal predictive power for stock market returns after accounting for state-dependent switching. We find strong evidence of predictability. The response of returns to the past price-dividend ratio is strongly asymmetric - about four times larger in the low-return state than in the high-return state. A second innovation in our work is to allow the probability of transitions from one regime to another to depend on economic variables.

Asymmetric Information, Liquidity Constraints and Canadian Investment

A new theoretical literature has suggested that the Modigliani-Miller theorem may not hold under imperfect information and that liquidity may affect a firms investment spending. This paper provides three original tests for such capital market imperfections based on predicted differences in investment between firms in different informational positions with respect to potential creditors or investors. The empirical tests suggest that information asymmetries have a large effect on investment behavior. The form of the tests reduces the likelihood of biases due to problems of endogeneity. The paper also examines the effect of differential measurement error on the tests.

Why Does Liquidity Matter in Investment Equations

That liquidity variables affect investment spending is widely accepted. Despite important recent empirical work, questions remain concerning the interpretation of liquidity variables in investment equations and the sources and economic importance of finance constraints. These questions are addressed by estimating a variety of econometric models that exploit distinctive Canadian institutional features to identify firms that face relatively severe information problems. The initial econometric evidence confirms the existence of finance constraints, and identifies their source as the problems faced by firms in credibly communicating private information to outsiders. This conclusion is robust to biases from the capitalization of finance constraints into asset prices, scale economies, or imperfect competition, which are accounted for directly in the econometric specifications. Copyright 1995 by Ohio State University Press.

The Predictability of Stock Market Regime: Evidence from the Toronto Stock Exchange

Are stock market crashes and rallies related to deviations from the apparent fundamental share price? Using a switching-regression framework, the authors test whether apparent deviations help to predict the regime from which the next periods stock market return is drawn and the magnitude of returns in that regime. They find that the probability of a collapse rises before most actual crashes. Likelihood ratio tests confirm that regime switches are influenced by apparent deviations. Copyright 1993 by MIT Press.

Bubbles, fundamentals, and investment: a multiple equation testing strategy

Abstract Dramatic fluctuations in the stock market raise questions about whether actual asset prices correspond to the expected present value of future cash flow and whether deviations from this fundamental price can affect real investment spending. Even if there are deviations from fundamental price, they may not distort real behavior if firms ignore these deviations in making their investment decisions. On the other hand, overvaluation of equities could provide firms with a relatively cheap source of finance and might therefore influence investment. To evaluate these issues, this paper introduces a new econometric testing strategy, and assesses the existence of stock market bubbles and the sensitivity of investment spending to bubbles. We estimate the Q and Euler equations in a simultaneous equations model and exploit the idea that these equations reflect different information about the stock market and investment spending. Based on U.S. data for 1911–1987, our formal statistical tests indicate that bubbles exist but real investment decisions are based on fundamentals. A variety of robustness checks and three types of collateral evidence corroborate this interpretation.

Fads or bubbles

Abstract. This paper tests between fads and bubbles using a switching regression to distinguish between competing models. Two main features of the bubbles model distinguish it from the fads model. First, the bubbles model implies that returns are drawn from regimes which differ in the way returns vary with deviations from fundamental prices. Second, the bubbles model implies that deviations from fundamental price will help predict regime switches. Using US data for 1926–89, we find evidence which is consistent with the fads model even when we allow for variation in expected dividend growth rates and expected discount rates. However, the restrictions which the fads model implies for a more general switching-regression specification are rejected. The rejections point in the direction of the bubbles model, although not all of the implications of the bubbles model are supported by the data.

The Interest Rate, Learning, and Inventory Investment

This paper presents a model that provides an explanation, based on regime switching in the real interest rate and learning, of why tests based on stock adjustment models, Euler equations, or decision rules—which emphasize short-run fluctuations in inventories and the interest rate—are unlikely to uncover a negative relationship between inventories and the real interest rate. The model, however, predicts that inventories will respond to long-run movements, that is, to regime shifts in the real interest rate. Tests emphasizing cointegration techniques confirm this prediction and show a significant long-run relationship between inventories and the real interest rate.

Finance constraints and asset pricing: Evidence on mean reversion

Abstract This paper investigates the potential effect of finance constraints on asset pricing, focusing on cross-sectional patterns of mean reversion. Theoretical work by Brock and LeBaron (1990) shows that in a production-economy version of the Lucas asset pricing model, finance constraints can accentuate mean reversion. Using panel data and distinctive Canadian institutional features which allow us to identify finance-constrained firms, we find that constrained firms show more evidence of mean reversion. Using a bootstrapping approach to inference, we show that the differences between constrained and unconstrained firms are statistically significant.

The Economic Effect of Sentiment

Based on the Stein (1996) model of financing and capital expenditures when market beliefs may be affected by sentiment, this paper directly estimates the effect of sentiment on hurdle rates. The hurdle rates are estimated for periods of high and low sentiment, making use of cross-sectional differences in the extent to which firms are hard to value and hard to arbitrage. Sentiment is measured using the Baker-Wurgler (2006) sentiment index. We obtain statistically precise estimates of the effect of sentiment. Low sentiment leads firms use higher hurdle rates. The estimated effects are large (600 basis points). High sentiment induces overinvestment for some firms; low sentiment induces underinvestment for other firms.

Retirement Income and the Lifetime Capital Gains Exemption: The Case of Qualified Farm Property and Small Business Corporation Shares

This paper examines the farm and small business LCGE. Our results of the farm LCGE provide only a partial support to the notion that it meets the special retirement needs of farmers. A large majority of the beneficiaries have income sources other than farming; however, many of them are near retirement age, earn relatively lower incomes and have relatively lower contribution rates. The small business LCGE results are quite different. A majority of the beneficiaries are younger and richer. Accordingly, the benefits of this measure seems to have gone to those who do not seem to require additional assistance for their retirement needs.